As you boarded your flight that day, perhaps you didn't realize you
were in the market for a garden statue that looks like Bigfoot. But, as
the plane doors close, you curse the FAA regulation that bans electronic
devices from being used during takeoff and landing. How do you
entertain yourself for these interminable 30 minutes? The inflight
magazine? The emergency safety instructions card? How about the SkyMall
magazine? Yes, the SkyMall magazine will do. And that's when you find
yourself considering whether you need the The Garden Yeti.

On
almost all US flights, you'll find SkyMall magazine in the seat-back
pocket in front of you. This magazine is a catalogue filled with
whimsical products that are available for sale. None of these products
are things you strictly "need". They're not even products that a
reasonable person could anticipate wanting until they've seen it -- a
baseball bat shaped pepper grinder, a vacuum cleaner to catch flies, an
alien butler drink tray, a helmet that promises to regrow your hair
using lasers.

Having
entertained ourselves by thumbing through the SkyMall catalogue
hundreds of times in our lives, but never having purchased anything, we
were curious. How does the business of SkyMall work?

As we were
researching the economics of the SkyMall business model, a darker story
emerged. SkyMall recently merged with a newly formed company called Xhibit Corp,
a company that trumpets itself as a "cloud" marketing software company,
but in reality makes its money from dubious sources. With even a small
amount of research, this company, Xhibit, raises all sort of red flags.

Has SkyMall, a quintessential piece of Americana, fallen in with a very bad crowd?

The Economics of SkyMallEvery
year, 650 million passengers have the opportunity to peruse through
SkyMall on their flight. According to a survey commissioned by the
company, over 70% of passengers read SkyMall on every flight.

The
company has negotiated deals with most major airlines in the United
States to be their exclusive product catalogue partners. This covers 90%
of passengers on US flights. Most SkyMall customers are exposed to the
products via the in-flight magazine, but they can order the products
using the catalogue or through the website, SkyMall.com.

For most
of its history, SkyMall has been a private company so its financial
information is not well disclosed. However, in 2009 its website
generated approximately $80.5 MM in revenue,
and it was the 185th largest e-commerce website by revenue, according to
the Internet Retailers Top 500 ranking. In interviews, company
officials have stated that 60% of the company sales
come through the website (the rest through the catalogue) so we can
estimate that the company does about $130 million in revenue per year
(website + catalogue).

The company was started in 1989 by Robert Worsley.
Worsley's original plan was that passengers could use the "Airphone" (a
phone that used to be located on the back of most seats) to call
SkyMall and when they landed, their purchases would be ready for them to
pick up. Customers could buy name brand merchandise from retailers like
Land's End, as well as SkyMall-branded products like luggage.

This
initial business model was a bit of a disaster. The company had to have
warehouses near the airports full with all the products in case someone
bought something. When a purchase was made, it would have to be quickly
transported to the gate. And it seemed no one really wanted SkyMall
branded-luggage. By 1993, the company was losing $6 million per year.

Around
this time, the company pivoted to a more capital-efficient model. They
wouldn't carry any products, they'd just be a magazine where other
companies could advertise. These companies would either pay a flat
advertising fee or pay SkyMall a percentage of each transaction. The
companies that advertise in SkyMall would be responsible to "drop ship"
their products directly to the customer. SkyMall would be an advertising
company in the vein of Google or eBay rather than an e-commerce company
that held inventory like Amazon.

Today, when you see a product
advertised on SkyMall, the company selling the product is paying
handsomely for the opportunity. A full page placement in SkyMall costs
$129K per issue (3 months) plus a 6% transaction fee. Or, you can opt to
pay a 5% transaction, a smaller advertising fee, and an additional
profit share with SkyMall. SkyMall sells space by the full page, half
page or quarter page. The cheapest option, a quarter page, costs $41K
per issue. Below are the monthly rates to buy space in SkyMall (it's required you buy three months at a time).

Taking
a percentage of each transaction and an advertising fee has been a
durable model for SkyMall. According to company President Christine Aguilera,
they get approximately 100 requests a week from prospective companies
to have their products featured in SkyMall. In order for this business
model to work, SkyMall needs to continue to be carried on nearly every
domestic flight to maintain its access to this captive audience of
travelers. It's not disclosed how large these fees are, but in 1999
(their last annual report), it was only around 5% of revenues.

Over
its corporate history, SkyMall has been owned by various private equity
firms who have passed it amongst themselves. Most recently, SkyMall was
owned by Najafi Companies,
a Phoenix based private equity firm that was best know for buying
Network Solutions in 2003 with a $20 MM equity investment, and then
later reselling the company for $800 MM in 2007.

And then, on May 17, 2013, a curious event took place that wasn't reported anywhere in the press. SkyMall merged with a company called Xhibit Corp, an entity which looks to be more of a parody of a tech company than a real company at all.

Xhibit Corp: a "Cloud" Company

Last
month, SkyMall merged with Xhibit Corp, a recently formed marketing
software and digital advertising company that trades on an "over-the-counter" exchange where equity shares of small companies can be bought and sold. As part of the merger, SkyMall owns 40% of the new company
and Xhibit owns 60%. Sounds like a merger of almost equals, with the
cutting edge tech company getting more ownership and the old economy
catologue business getting less, right?

Except here's the problem.
Skymall is by all accounts a reasonably successful company with $130
million in annual revenue, a differentiated offering, a well known
brand, and at least some happy customers. Xhibit on the other hand,
appears to be a company with dubious sources of revenue, a very thin
competitive advantage, and more hype than substance.

The Xhibit Corporation went public via a "reverse takeover" of a shell company in 2012.
Earlier, in 2011, the individuals behind the company acquired a shell
company called NB Manufacturing for $350K, and voila, Xhibit was able to
become a publicly traded company. The SEC
warns that investors should be wary of putting their money in companies
that become public this way because there is essentially no regulation:

Reverse
mergers permit private companies, including those located outside the
U.S., to access U.S. investors and markets by merging with an existing
public shell company. The SEC and U.S. exchanges recently suspended
trading in a more than a dozen reverse merger companies, citing a lack
of current, accurate information about these firms and their finances...

"Given
the potential risks, investors should be especially careful when
considering investing in the stock of reverse merger companies," said
Lori J. Schock, Director of the SEC's Office of Investor Education and
Advocacy.

When Xhibit merged with Skymall, it's market capitalization was about $300MM.
How does a company go from $350K valuation to $300MM in under two
years? The answer is that if a security is fairly illiquid, the "price"
is more or less arbitrary because people aren't really buying or selling
many shares. If only a few shares are trading on the market, the price
can be really high, regardless of the fundamentals of the company. If
there is substantial "hype" about this company, the price of these very
limited shares will be high. But, if the insiders unload most of their
stock, the share price would plummet. Maybe Xhbit is worth a lot of
money, maybe it's not. There is no way to tell by just looking at the
stock price if there isn't a vibrant and liquid market for the security.
Below is the Xhibit Corp (XBTC) stock price over the last two years:

But
what does the company do exactly? Is Xhibit the kind of company that
should be trading at 30X revenue? Here's how Xhibit Corp describes itself:

Xhibit is a cloud based technology development company with its primary historical focus on digital advertising, and a recently expanded focus on online and mobile social media, games and CRM (customer relationship management) solutions.

It
hits all the buzzwords, sounds like it should be trading at a huge
multiple to revenue since it's some sort of cloud social crm something
company. But if you take a look at their website,
everything that comes after the words "recently" don't really exist
yet. The social games and social media sites (like much anticipated
social network, "Twityap") haven't been launched yet. The realtime ad
exchange hasn't launched yet. The email marketing CRM solution has
"several customers" according to the company's latest annual report. So most of how the company presents itself is vaporware.

However,
the company made $9.2 MM in revenue in 2012, with very healthy 52%
gross margins. That sounds pretty good, but where does it come from? The
answer comes buried deep in it's annual report:

During
the first quarter of 2013 a majority of our revenues have been
generated by these five employees from the sales of a weight loss
product, colon cleanser and green coffee supplement...

As the
profit margins for sale of these products is far higher than online
marketing of education, home business or other services we have
traditionally advertised, we have re-directed our advertising resources
to this sector.

Ah, the answer to how Xhibit makes
money. The company made money this year by selling spammy weight loss
products. Last year, the company made money by selling online education
and home-based business leads, but the profit was much better in
nutraceuticals! But alas, this is a high risk game and the company's
merchant banks aren't releasing the funds from recent credit card
transactions:

None of our merchant banks were willing
to immediately release the cash to us after they processed the credit
cards used by our consumers to pay for these nutraceutical products. The
combination of taking credit card numbers over the internet, selling
products subject to more frequent returns, and selling products overseas
resulted in a change in the policies of the merchant banks as they were
concerned with a greater number chargebacks.

Failure to get the
cash from these sales immediately with a potential delay as much as 100
days may result in the failure to meet other obligations on a timely
basis, delay research and development or even impact our ability to meet
payroll. We plan to raise short term capital to fund these sales.

So,
in the best case the iconic SkyMall has merged with a company that
makes its money selling spammy weight-loss products but poses as a
marketing software company. The worst case could be much worse.

Six months ago (well before the merger with SkyMall), Issac Silberman,
a contributor to Seeking Alpha put forth a hypothesis that would
explain most the actions by Xhibit and its management team - the company
might be a run of the mill "pump and dump" scheme to defraud investors.

According
to Silberman, it's really nothing too complicated: become a publicly
traded company without SEC scrutiny, hold most shares among insiders so
that price is artificially high, hype up the stock with phrases like
"cloud", "real-time" and "social", and then unload the shares to
unsuspecting investors. Silberman makes a compelling case that this is
why a company of dubious origin is supposedly "trading" at nearly a
$300MM valuation like it's the second coming of Salesforce.com. Even
Silberman's hyper-critical analysis overlooks that the company makes all
its money from selling spammy weight loss products, not from cloud
software.

There is almost too much bizarre information about
Xhibit and we're barely scratching the surface. To dig deeper, we'd
encourage you to read this Seeking Alpha article, look at their corporate site full of vaporware, take a gander through their annual report, or listen for a few minutes to this strange "interview" with the company's founder Chris Richarde.

When
all this information about the sketchy nature of Xhibit Corp is
available, why would the owners of SkyMall willingly exchange the shares
of their company for shares of Xhibit Corp? Why would an American
institution with strong revenue sources merge with what's in the best
case a very crappy tech company, and in the worst case, something the
SEC should be investigating?

ConclusionTo us, it's a bit sad that SkyMall has fallen in with such a bad crowd. It's also very confusing.

SkyMall,
was owned by a private equity firm that by all accounts is
sophisticated and knows how to structure deals to its advantage. This
leaves three possibilities for why Najafi Companies would merge with
Xhibit 1) There is some arcane tax or financial benefit that accrues to
them through this kind of merger 2) They understand whatever scheme
Xhibit is working on and think it's a good business idea 3) They got
tricked into the acquisition.

We'll admit to be completely
confounded. The owners of SkyMall are pretty smart so it's unlikely they
got tricked or Xhibit's shaky finances weren't uncovered during due
diligence. Moreover, if there is some tax benefit to this kind of
merger, why not merge with a less sketchy company? It's a mystery to us.

So
dear readers and financial sleuths, can you figure out the curious case
of the merger between the great SkyMall and the lowly Xhibit Corp? Is
there some financial benefit here for the owners of SkyMall, or did they
get sold a bill of rotten goods, perhaps as karma for the decades of
using their catalogue to sell a bunch of lovable but useless junk?

This article also appeared on the Priceonomics blog, a content partner

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